Pricing of an interruptible service with financial compensation and rational expectations

Abstract

This paper proposes a pricing framework that combines the occurrence of supply interruptions with financial compensations. Consumers post ex ante demands for a designated period. These demands are met if ex post supply capacity is sufficient. However, when supply is inadequate, all ex ante demands will be equi-proportionally rationed with compensation being paid for any unserved demand. Consumers posts their demands based on their expectations on the reliability of the supply system. The model is closed by imposing rational expectations. We identify that while a consumer's ex ante power demand will be decreasing in the power price and increasing in the compensation rate, it will be increasing when there is a mean-preserving spread in the riskiness of future supplies, provided the consumer is sufficiently prudent, i.e., when his coefficient of relative prudence exceeds two, and his coefficient of interruption aversion exceeds one. We also derive the welfare maximising price and show that when consumers are sufficiently prudent, pessimistic (equilibrium) expectations on the supply reliability warrant a higher price compared with a situation of supply adequacy.